Morgan Stanley Warns Of “Boom And Bust In Credit”

The prospect of a Trump presidency has already made a profound impact on markets. It has, for example, caused a sharp shift from bonds to U.S. equities, sparked a sell-off in emerging markets, set the dollar on a higher trajectory and, by many accounts, paved the way for Trump to “make America great again”, but warns of risk in the credit markets.

But a stronger America might not mean the best opportunities lie at home. In fact, Morgan Stanley thinks the highest returns will come from outside the United States.

Market’s optimism in U.S. equities

“We think the market is too optimistic on the ability of fiscal policy to boost U.S. equity markets, yields, or yield curves from current levels on a full-year basis, given the headwinds from a stronger USD and tighter financial conditions,” wrote London-based Andrew Sheets of the bank’s Cross Asset Strategy team.

In contrast, “Europe will see more curve steepening, while Japan and Europe should see higher equity returns and more upside to inflation versus expectations.”

Morgan’s trade call is specific:

“Sell U.S. equities to buy Japan. Sell the front end of U.S. rates and long-end EGBs. Buy volatility in equities, credit and rates (but sell it in EMFX). Own securitized products over corporate credit.”

The other major call from Morgan’s 2017 Global Strategy Outlook, released Nov. 27, is the higher odds of a boom and bust, consistent with a late-cycle environment.

“Our new forecasts call for higher growth, inflation and policy rates than before, an uncertain cocktail for an expansion that is already one of the longest on record,” Sheets said, reversing the bank’s longstanding projection of “slow growth, slow reflation and slow policy normalization.”

The bank analysts warn:

Let us emphasise another point:

2017 is a year where our odds of a boom and bust have both increased. We see that consistent with a more late-cycle environment, especially in the US, and means we now expect credit to under- perform equities in the US, Europe and China.

…….

This is a change. Our long-running narrative had been “slow growth, slow reflation, and slow policy normalization”, a backdrop that we’ve seen as favorable to credit. The prospect for more fiscal stimulus in the US and elsewhere affects all three.

We now expect six Fed rate hikes through YE18, the ECB to consider tapering in 2H17, and a shift of the BoJ’s 10yr yield target in 4Q17. Poli- cy easing in 2017 is an EM story,

And….

A bear case also looms. Higher growth and inflation could lead to a more hawkish central response than we expect. Corporate lever- age is unusually high for this point in a cycle expansion. Risk premi-ums, while not extreme, are hardly ‘cheap’ across asset classes.

U.S. Equities

The boom and bust scenario is especially seen likely in the U.S., where an expected fiscal stimulus could boost growth, accelerate earnings, and bring back “animal spirits…in a way they haven’t so far in this cycle.”

But equally a bear case looms. Reflation could falter beyond the first quarter of 2017 on a strong dollar, a more hawkish Fed and slowing China.

“Higher growth and inflation could lead to a more hawkish central response than we expect. Corporate leverage is unusually high for this point in a cycle expansion. Risk premiums, while not extreme, are hardly ‘cheap’ across asset classes,” the bank said.

Morgan was also less upbeat about Trump, pointing out that “a trend of rising yields, steeper curves and better earnings has been in place for months” before the U.S. election.

“An initial lack of policy clarity from the Trump administration may actually be helpful, in our view, allowing investors to believe that the U.S. ultimately will pursue ‘good’ projects (e.g., infrastructure spending) and avoid ‘bad’ ones (trade protectionism), while dangling the possibility of large corporate tax cuts.”

Morgan also predicted six Fed rate hikes through 2018, and an end of policy easing in developed markets. It expects the ECB to consider tapering in the second half of 2017, and a shift of the Bank of Japan’s 10-year yield target in the fourth quarter.

However, emerging markets would witness policy easing, with cuts likely in Brazil, Russia and Korea.